Reasons to Worry About Herbalife: Greenberg

Herbalife, whose stock tumbled last week after hedge fund manager David Einhorn asked a few questions on the company’s earnings call, is no stranger to controversy.

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Herbalife 24

The company first hit my radarin March after CEO Michael Johnson said on Jim Cramer’s Mad Money that Herbalife does research “around the clock.” Yet in its 10-K, the company discloses that its research spending is “not material.”

Best known for its weight-loss shakes, Herbalife likes to bill itself on its website as a “global nutrition company.” But it’s really in the business of multi-level marketing — or as it calls itself: “A global network marketing company that sells weight management, nutritional supplement, energy, sports & fitness products and personal care products.”

And not just any multi-level marketer, but “we are one of the largest network marketing companies in the world.”

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By its nature, the centerpiece of the network marketing model is to recruit salespeople whose primary goal is to recruit other salespeople. “We are committed to providing our distributors with unique, innovative products to help them increase retail sales and recruit new distributors,” the company says in its 10-K. The ultimate goal, if all goes right, is to share in the profits of others up and down the line — or in the “upline” and “downline,” as they call it.

While the company says in its 10-K most distributors who take advantage of Herbalife’s “business opportunity” experience a high “turnover rate,” the formula has been a winner for the company and its shareholders.

Greenberg on Herbalife

Shares of Herbalife are dropping since David Einhorn questioned the company's disclosures during a conference call, with CNBC's Herb Greenberg.

Last year revenue surged more than 26 percent to $3.5 billion. And before its recent plunge, its stock had more than tripled in two years; even with the slide it has more than doubled.

The business has done so well that, as I reported last week, Johnson is among the highest paid CEOs in the country, with annual compensation last year of nearly $90 million, according to GMI Ratings.

But there are reasons for investors to worry.

Reasons for investors to worry.

Consumer by any other name

The top reason, as it turns out, was the first question Einhorn asked on the call: How much product is sold to customers outside the company?

In a responseon its website and in an SEC filing, Herbalife said: “We don’t track this number and do not believe it is relevant to the business or investors.”

Yet, based on my research and discussions with multi-level marketing experts and former distributors, it may be the most relevant question.

Without mentioning any company by name, David Vladeck, Director of the Bureau of Consumer Protection of the Federal Trade Commission, told me Monday that it would be “red flag” if a multi-level marketing company didn’t keep track of unrelated customers.

An illegal pyramid scheme?

The “customer” issue strikes to the heart of the ongoing (and broader) controversy surrounding multi-level marketing companies like Herbalife: Are they pyramid or Ponzi schemes?

The question is so compelling that Herbalife itself includes the question on its websiteamong those frequently asked about “business practices.” In explaining why it believes it isn't a pyramid or Ponzi scheme, the company says: “Pyramid or Ponzi schemes are illegal, while multilevel or network marketing organizations such as Herbalife are carefully regulated and are legal business structures that involve the sales of real products of value to consumers.”

But it’s not that simple and there are plenty of gray areas and legal interpretations within the regulation — so much so that in its 10-K Herbalife cautions that “the legality” of its model is at the risk of “private party challenges.”

Legality cited as a risk

Indeed, in its 10-K, Herbalife warns:

“We are subject to the risk that, in one or more markets, our network marketing program could be found not to be in compliance with applicable law or regulations.

Regulations applicable to network marketing organizations generally are directed at preventing fraudulent or deceptive schemes, often referred to as ‘pyramid’ or ‘chain sales’ schemes, by ensuring that product sales ultimately are made to consumers and that advancement within an organization is based on sales of the organization’s products rather than investments in the organization or other non-retail sales-related criteria.

The regulatory requirements concerning network marketing programs do not include ‘bright line’ rules and are inherently fact-based and, thus, we are subject to the risk that these laws or regulations or the enforcement or interpretation of these laws and regulations by governmental agencies or courts can change.

The failure of our network marketing program to comply with current or newly adopted regulations could negatively impact our business in a particular market or in general.”

The company further reminds investors that in 1997 Omnitrition International, another multi-level marketer, lost a class action lawsuit that claimed it was an illegal pyramid scheme. The crux of the ruling in the U.S. Ninth Circuit Court of Appeals in California, which includes Herbalife’s Los Angeles headquarters, is that distributors don’t count as retail sales.

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Herbalife uses the term “retail sales” 35 times in its 10-K, and says “we discuss retail sales because of its fundamental role in our compensation system, internal controls and operations…”

But it is vague about what they really are. According to the 10-K, “‘Retail sales’ represent the gross sales amounts on our invoices to distributors before distributor allowances…”

Herbalife goes on to say it believes it meets all legal qualifications “defining a legal network marketing system, in part based upon significant differences between our marketing system and that described in the Omnitrition case.”

Federal judge questions model

What the company doesn’t say is that in 2009, in a legal fight with a former distributor, Ninth Circuit district Judge Gary Feess ruled that the question of whether Herbalife is an illegal “endless chain” was trial-worthy.

During a hearing, he told Herbalife's attorneys that while the company had created rules designed to keep it on this side of legal, “looking at the record I have serious question as to whether or not those are exalting form over substance and aren’t just there for the purpose of creating the impression” that the legal tests have been met.

The case was settled out of court.

Ruled a “pyramid scheme’ in Belgium

Meanwhile, in Belgium: After a six-year legal fight, the Commercial Court in Brussels last year ruled Herbalife was operating an illegal pyramid scheme.

“Contrary to what Herbalife is arguing, this case does not show that the distributors are selling to the end customers,” the court ruled.

Herbalife says it intends to appeal.

Founder dies of overdose

Herbalife was founded 32 years ago by entrepreneur Mark Hughes, a health zealot who died of what the company says was an “accidental overdose of prescription medicine and alcohol.”

While the company says it has 138 products, Hughes’s original Formula 1 shake still accounts for 29 percent of sales sold worldwide through 2.7 million distributors.

Of those distributors, only 20 percent become so-called “sales leaders,” which mean they buy enough products to qualify for bigger discounts and impressive titles, such as “supervisor” or “world leader.”

Most distributors quit

Yet after paying the company from hundreds to thousands of dollars, most distributors quit. “Our distributor organization has a high turnover rate, which is a common characteristic found in the direct selling industry,” says Herbalife in its 10-K.

Until 2006, the company disclosed a turnover rate of 90 percent. It now merely says that “typically” distributors “who purchase our product for personal consumption or for short term weight loss or income goals may stay with us for several months to one year.”

In addition, more than half of all sales leaders don’t make it past a year, according to SEC filings.

Even among sales leaders, the income for most is meager. While the company’s “business opportunity” literature touts a “generous compensation plan” and shows success stories of people who have created “thriving” businesses, the fine print tells another story: According to “the statement of average gross compensation” link at the bottom of the company’s main “businesses opportunity page” on its website, “The annual gross compensation paid by Herbalife to all Leaders during 2011 averaged $2,900.” The biggest group of all sales leaders, supervisors, earned an average of $901.

Herbalife has no sustainable customer base,” insists Robert Fitzpatrick, author of “False Profits,” who also operates the website, Pyramid Scheme Alert.

What about the Federal Trade Commission?

What about the FTC?

The Federal Trade Commission, for its part, has filed few cases against multi-level marketing firms in recent years. In March it won a case against BurnLounge, a small online music retailer, which was deemed an illegal pyramid scheme. Before that, its last big case was in 2000 against the now-defunct Equinox International.

One reason there are so few multi-level marketing cases now, Vladeck says, is that the commission doesn’t receive many complaints. With Herbalife, for example, so far this year it has received only 18 complaints, many of them immaterial. Last year there were 37, and most of those related to unsolicited phone calls. The year before that — 36, nearly triple 2009; in 2006 there was only one.

Vladeck says that while up sharply, such numbers amount to a “puddle,” making it hard for the FTC to justify a deeper look.

But there are other reasons that should probably be considered as well. The theme I’ve heard most from distributors in my reporting: A mix of embarrassment and the feeling that even if they do complain — nothing happens.

One former distributor, Nicole Lopez of Provo, Utah, who says she lost money on Herbalife, says she was told she was getting involved with “a proven business model — and the only variable is you.”

Fitzpatrick, who has tracked pyramid schemes for 14 years, adds that people have stopped complaining “because they feel it is futile to complain because the FTC has stopped investigating. States have taken their cue from the FTC and they will not take on these companies. Meanwhile the companies have lawyered up, gotten far larger…and have convinced millions of people that if they failed it was their own fault.”

No disclosure of failure rate required

To complicate this a little further: An important part of the Herbalife and multi-level marketing story is the Federal Trade Commission’s new Business Opportunity rule, which went into effect in March after five years of deliberation.

As proposed, the rule would require multi-level marketers to disclose the number of distributors who sought a refund or canceled over a two-year period. The impact of the rule was so potentially damaging that Herbalife warned investors that if it was passed, it “would negatively impact our U.S. business.”

Yet the final rule, enacted in March, specifically excluded such disclosures by multi-level marketing.

After being hammered by the powerful Direct-Selling lobby, “and more than 17,000 letters,” according to Herbalife, the commission said that while it was aware “some MLMs do engage in unfair or deceptive acts,” it wasn’t persuaded that “meaningful disclosures could be devised that would help consumers identify a fraudulent pyramid scheme. This being the case, the Commission decided that the proposed Rule was too blunt an instrument to alleviate fraud in the sale of MLMs.”

It’s all elementary

Which gets us back to Einhorn’s original questions. In a press release responding to the slide in its stock, Herbalife said his “were elementary questions usually asked by investors new to our industry. These are issues that have been thoroughly addressed before.”

Perhaps, but says Fitzpatrick, the pyramid scheme expert: “To say that the question of retail sales level is ‘elementary’ and has been answered by claiming the salespeople are the consumers — is extraordinary. They appear to be relying on the widespread ignorance on Wall Street about MLM business model and the legal restrictions and definitions that apply.”

Minkow, who served seven years in prison for being the mastermind behind the ZZZZ Best fraud, is now serving five years in prison for conspiring to manipulate Lennar, another company he had targeted).

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In response to my question, the company issued a statement, saying that it settled with Minkow to avoid further legal expenses.

Herbalife added, “We are totally committed to using every resource to defend against any misrepresentation by short sellers, their accomplices and associates.”

A spokesman for Einhorn declined comment when asked whether Einhorn is short Herbalife.

This note: Since responding to my Minkow inquiry, in recent days Herbalife has not answered subsequent telephone or email inquiries — including one with a question related to this story. In March the company had invited me to tour its headquarters, see its lab and interview Johnson. We had a tentative date, but it has not responded to multiple requests to confirm it.